Contributions to Coverdell Accounts

The basic rules for contributions to Coverdell accounts are pretty
simple. The details of these rules are — well, let's just say
Congress wasn't thinking carefully when they wrote these rules. Fortunately,
most people won't have to deal with the strange twists we'll note below.

Who Can Contribute

Subject to the income limitation described below, anyone can
contribute to a Coverdell account for a particular child.
Parents, grandparents, aunts and uncles — even a friend of the
family can set one up. The child can even contribute to his or
her own Coverdell account. And that's not all: corporations and
trusts can contribute. You don't need to have earned income (or
any income at all) to contribute to a Coverdell account. As
discussed below, you can't contribute if your income is too
high, but most people can get around that rule if they really
want to set up a Coverdell account.

Timing of Contributions

Contributions must be made before the beneficiary turns 18.
You're allowed to make a contribution during the same year the
beneficiary turns 18, but you should make sure it goes into the
account before the beneficiary's 18th birthday.

Although you can't contribute to an account
after the beneficiary turns 18, you can change an account from
one beneficiary to another who is over 18 but not yet 30.

You can contribute for a particular year any time from the
beginning of that year until the April 15 of the following year
(or to be technically precise, the beneficiary's return due
date, without extensions). If you contribute between January 1
and April 15, be sure to specify the year for which you're
contributing.

Cold Hard Cash

All contributions must be in cash. If you want to use
something else, like stock, you have to sell it (reporting gain
or loss) and contribute the sale proceeds.

No Deduction

You don't get a deduction when you contribute to a Coverdell account.
It's important to keep track of the amounts you contribute, though. As we'll
see later, if there is ever a taxable distribution, the portion of the
distribution that's considered a return of contributions is not taxable.

Per Child Contribution Limit

The annual contribution limit is $2,000 per child. If you
have three eligible children you can contribute $2,000 for each
of them. But you can't contribute more than $2,000 for any one
child even if you set up multiple Coverdell accounts for that
child. What's more, if someone else has contributed to a
Coverdell account for the same child, the amount you can
contribute is reduced. The $2,000 limit applies to all
contributions from all
contributors to all Coverdell accounts for any one child
for a given year.

Example: Your sister-in-law put $1,200
into a Coverdell account for your daughter earlier this year. If
you also want to contribute to a Coverdell account for your
daughter (the same account or a different one), the amount you
can contribute is limited to $800.

If you're contributing to a Coverdell account
and believe there's a possibility anyone else might set one up
for the same child without telling you, it's a good idea to get
the word out. Excess contributions lead to burdensome paperwork
and, if not promptly corrected, a tax penalty for the
beneficiary.

This is the first place we run into something strange in
these rules. The way the law reads, ten different people could
set up Coverdell accounts for the same person without telling
anyone else. Each of them could contribute $2,000, and all but
one of them would be making excess contributions,
potentially resulting in a penalty.

The IRS tried to address this problem in the forms used to
set up Coverdell accounts. These forms say the person who is
setting up the account (called the grantor or the
depositor) has to name a
responsible individual to be in charge of the account, and
this person has to be a parent or guardian of the beneficiary
(the child). Technically, you aren't required to use the IRS
forms to set up a Coverdell account, but most banks or other
trustees will require you to do so. That should take care of the
problem, unless different parents or guardians for the same
person become responsible individuals for different Coverdell
accounts without telling each other.

Income Limitation

If your income is higher than the level specified in the tax
law, the amount you can contribute to a Coverdell account is
reduced or eliminated. The income that counts for this purpose
is your modified adjusted gross income (or modified AGI).
Adjusted gross income is the amount left after claiming certain
types of deductions (such as business deductions and
contributions to a traditional IRA) but before you take
exemptions or itemized deductions. On a regular Form 1040, it's
the number at the bottom of the first page of the return.

To arrive at modified AGI, you have to increase your adjusted
gross income by certain amounts that may have been excluded from
your taxable income. These items relate to earnings outside the
United States, so for most people modified AGI is the same as
adjusted gross income.

For married taxpayers filing jointly, the $2,000 contribution
limit begins to be phased out when modified AGI exceeds
$190,000, and is completely phased out when modified AGI reaches
$220,000. For all other taxpayers the $2,000 contribution limit
begins to be phased out when modified AGI exceeds $95,000, and
is completely phased out when modified AGI reaches $110,000.

Example:
Suppose the modified AGI on your joint return was $197,500.
That's one-fourth of the way from $190,000 to $220,000, so
one-fourth of the $2,000 limit is eliminated. You can contribute
only $1,500.

Avoiding the Income Limitation

The income limitation for Coverdell account contributions are
so generous that few people have to worry about it, but if
you're one of those people, there are ways to get around it.

One way is to have the child make the contribution. Nothing
in the law prohibits this, and the IRS explicitly says, in
Publication 970, that this is possible. To do this, you must
first make sure you've made a completed gift to the child, which
may be a transfer to a custodian under the Uniform Transfers to
Minors Act. It appears you could name yourself as trustee or
custodian, but you must go through the necessary paperwork of
getting the money into a custodianship before moving the money
into a Coverdell account. Once the money is in a custodianship,
the contribution is coming from the child, and the income limits
don't matter unless the child has over $95,000 of income. You
would fill out the Coverdell account forms as custodian for your
child's assets.

If you take this approach, you should set up
the Coverdell account to prohibit a change in beneficiary. You
want to make it clear that this contribution was from money
owned by the child, so it isn't appropriate to retain the right
to change the beneficiary to a different child.

As noted earlier, trusts and corporations are also allowed to
contribute to Coverdell accounts. There is no income limitation
for contributions by trusts or corporations, so if you happen to
have a trust or corporation you can use for the contribution,
you can avoid the income limitation that way also. The problem
here is that the Treasury has not seen fit to explain the tax
consequences of such contributions, other than to say they are
allowed under the rules for Coverdell accounts. Presumably, if
you own a corporation and cause it to contribute to a Coverdell
account for your child, the contribution is some form of income
to you — wages or a dividend — but the present rules leave this
to our imagination.